Article No. 114

Business Practice Findings, by James Larsen, Ph.D.

New Business Formation

Researcher identifies factors that spur the formation of specialized small companies.

Right now entrepreneurs are watching for signals that
will tell them the time is right to start a new business.
Have you ever wondered what those signals are?

Anand Swaminathan, from the University of Michigan, has
investigated this topic, and he recently discovered a rich
source of information to explore: a complete record of
business foundings in the American wine industry.

The U.S. wine industry rose like a phoenix from an
extinction imposed by Prohibition. By 1940 1,033 wineries
were in operation. But a downward trend began with the war
and continued for 27 years, even though sales increased
steadily during the period. By 1967, only 330 wineries
remained, but then the trend reversed and by 1990, over 1,300
wineries were in operation.

Professor Swaminathan compiled data from government
reports and trade periodicals and he considered demographic
information on population and income looking for factors that
accelerated the establishment of small, specialized wineries
that catered to local markets. In the industry, these are
called
farm wineries.
He found 4 factors.

One factor was evolving customer preferences (market
niches). Small businesses are well suited to exploit these
opportunities. Interestingly, Swaminathan discovered a
source of data that signals the emergence of a customer
niche, an increase in imports. So this was one of the
signals entrepreneurs in the wine industry noticed that
spurred them to establish new firms.

A second factor involved the actions of large companies in
the industry. Typically, as their market shares grew, they
absorbed smaller firms. This led to a few large companies
dominating the industry and competing vigorously for the
center of the market. They streamlined production and
distribution, standardized product features, and targeted
their advertising at large, national market segments. They
ignored the fringes of the market. Localized customers with
special preferences offered an opportunity for entrepreneurs
to establish firms to address their tastes. Swaminathan's
analysis demonstrated an acceleration of winery foundings
when these conditions existed. This is another factor
entrepreneurs noticed.

A third factor can best be described as following the
leader rather than the follower. It proved to be responsible
for both accelerating business foundings and retarding them.
When the number of wineries was low, in 1967, for example,
the first new farm wineries attracted attention. They
demonstrated a new way of entering the industry, a new form
of business that others could copy. Swaminathan analyzed
founding data state by state, and found each new farm winery
accelerated the establishment of new farm wineries, like bees
swarming to a rich source of nectar. But when the number of
wineries was high, then establishing a new firm led to a
decline in the founding rate, a slow down reflecting a
saturation of the opportunity. Entrepreneurs noticed this
factor too.

A fourth factor involved legislative and association
support. In 1968 Pennsylvania pioneered legislation
supporting farm wineries and new business foundings rose
dramatically. Other states soon followed their lead. The
federal government also granted an exemption of an excise tax
increase for the first 100,000 gallons of a winery's
production, which gave them a competitive advantage over
large firms. So supportive legislation and association
activities are also factors that led entrepreneurs to begin
firms.

Finally, Swaminathan compared the factors and found
"following the leader" to be by far the most influential,
followed by reacting to large firms' neglect of market
fringes as they competed for the center. Favorable
legislation and association support followed next, and
emerging customer niches followed close behind.

Entrepreneurs have an unsettling ability to change
everything in an industry, revitalizing it whether
established firms like it or not. Swaminathan believes his
findings apply to many industries, and now, thanks to his
work, we have a keener insight into factors that spur
entrepreneurs to act.